Banks’ Hyper-Hedging Adds to Risk of a Market Meltdown

JPMorgan (JPM) Chase & Co.’s lost billions
remind us that modern finance has changed the world, and not in
ways that we should celebrate. Nothing demonstrates this more
than the use of hedging.

It is debatable whether hedging makes individual banks such
as JPMorgan “safer,” and very debatable whether it makes them,
on balance, more profitable over time. But even supposing that
hedging does, or can, assist individual firms, their trading has
an unseen and pernicious effect on markets overall. Just as
football players armed with kryptonite-strength helmets hit more
aggressively, leading to more concussions, hypertrading by firms
-- each thinking of their own preservation -- has exposed
markets to meltdowns and routs.

Market participants themselves are mostly unaware of their
effect on the group because they have grown up in a culture that
celebrates trading -- hedging, in particular. The attitudinal
change, fostered by technology, has been gradual but vast, and
only visible if one steps back and remembers how things were.

Let’s go back a generation, and drop in on the leading
banker of the day (we’ll call him Old Jamie). Old Jamie lives in
a world with few options for dealing with risk. Suppose that Old
Jamie and his team are pouring martinis on a Friday afternoon
when the house economist wanders by. “Sorry boss,” the economist
says, “but Europe is looking bad. Some of our drachma, franc and
lira loans might be underwater.”

“Well,” Old Jamie ventures, staring at his olive as if in
search of a solution, “is there a way we can sell these loans?”
“No, sir,” his economist says. “You see, other people think
Europe is slowing down, too. To be honest, I read about it in
this morning’s paper.” “I see,” says Old Jamie, who is thinking
he will need a second martini. “Well, I guess we’ll have to take
some losses.”

Few Alternatives

And in truth, Old Jamie had few alternatives. Today’s world
is vastly different. Let’s review what has been reported about
the present-day Jamie Dimon, chief executive officer of
JPMorgan. This Jamie has loans in Europe, too. Last summer, you
will recall, people were saying the Europeans owe too much money
and don’t work enough to pay their debts. This isn’t news to
anyone who has ever been to Europe, where the people spend most
of their time discussing philosophy in cafes. But when some
economists -- probably after having vacationed in Europe --
noticed this, they forecast a debt crisis and a recession.
Instead of sitting on its prospective losses, as the old Jamie
did, the new Jamie (or rather, his traders) bought insurance.

Of course, JPMorgan didn’t buy regular insurance, such as a
policy from Allstate Corp. or State Farm. It bought credit-
default swaps tied to an index of corporate bonds. If the bonds
went south, according to what has been reported, JPMorgan would
collect on its synthetic policy. But if they didn’t, the bank
would keep making premium payments, in effect forgoing the
profits from European and possibly other loans. (The exact
strategy was complex and hasn’t been fully disclosed, but
clearly the bank was worried about Europe and possibly spillover
effects in North America, too.)

Now some months went by, and Jamie’s economists are not so
worried anymore. By now their summer vacations are just a
distant memory. So the bank decides it really does want exposure
to corporate bonds -- storm clouds in Europe or not. It writes
new contracts in which it will receive money if certain
corporate bonds hold their own, but it will, of course, pay out
if they go under. In a perfect world, the two sets of
derivatives cancel each other out -- that is the meaning of the
term “hedge.”

’Stupid’ Trades

But the world isn’t perfect -- not even for a trader at
JPMorgan. Certainly, the bonds underlying JPMorgan’s opposing
hedges weren’t a perfect match, and on a net basis, the bank, it
would seem, ended up with exposure to Europe. Now, on toward
spring, people are getting nervous again. Maybe they are
planning another vacation to Paris or Seville. European
government and corporate bonds go back in the tank, and JPMorgan
loses $3 billion and maybe more.

Give Jamie credit for describing complex trades with a word
you’d hear on the playground -- “stupid.” He didn’t say what,
exactly, he was referring to, but one can guess. That second set
of trades -- when JPMorgan was using the derivatives market to
sell insurance -- was clearly a speculation. And if I were
writing the regulations to implement the Volcker rule, which
prohibits proprietary trading by banks, I would bar any bank
from ever selling a credit-default swap. If you want to gamble,
go to a casino. If you want to sell insurance, get a license
from the state commissioner (who, by the way, will regulate your
capital).

Now, the other part of JPMorgan’s trade, the initial one,
when it purchased credit-default swaps, is a little more
interesting. What JPMorgan and other banks say is that this
isn’t speculating, it is risk reduction: hedging. And the
Volcker rule, apparently, would permit such trades.

Of course, JPMorgan doesn’t own the exact bonds it is
buying insurance on. It is buying protection on some corporate
bonds that it thinks are almost always -- well, usually -- going
to move in the same direction as the loans on its books. Of
course, there is always the chance that JPMorgan doesn’t own
such a portfolio of loans and that it is just speculating.
Certainly, that is what some -- actually, most -- people in the
CDS market are doing. But let’s assume Jamie is doing what he
says: hedging.

Here’s the problem. In the era of Old Jamie, if someone in
Europe wanted to borrow money, and if Jamie was a conscientious
banker, he had to think long and hard about whether the customer
was a good risk. In all likelihood, those customers would be
with him for a long time.

Relaxing Credit Standards

The new Jamie, and the people working for him, don’t have
to worry quite so much. They know that if they become
uncomfortable with the loans they can always hedge them in the
derivatives market. I have heard this offered as a defense of
credit-default swaps from executives of JPMorgan. Were it not
for the ability to hedge, they wouldn’t make all the loans they
do. Hedging becomes an excuse for relaxing credit standards.

There’s another problem. When JPMorgan hedges, it doesn’t
get rid of the risk. That only happens when the customer repays
the loan or, say, improves its balance sheet. JPMorgan’s hedges
didn’t make the risk disappear; they merely transferred it to
someone else.

Jamie had an escape hatch, but hedging doesn’t offer an
escape for markets as a whole. To sum up, thanks to these
instruments, banks take more risks than they otherwise would and
thus more risky bets are collectively owned by society. Only now
the traders who set the market price are removed from the credit
itself. In the past, Jamie and his team knew the borrower and
evaluated the credit (the original J.P. Morgan Sr. famously
testified that an individual’s “character” was the basis of
credit).

JPMorgan still issues loans but with half an eye on their
“hedging” potential, that is, on the willingness of traders who
may be halfway around the globe to assume the risk. These
traders are less well-placed to evaluate the risk. They don’t
know the customer and, of course, they haven’t the faintest
concern for character. By habit and preference, their
involvement is apt to be brief.

They assume risk by writing a swap contract in the full
knowledge that they can unwind it via another swap days or even
hours later. Someone may get stuck with the bad coin but, each
trader is certain, it won’t be him or her. So the approach of
these traders is inherently short-term -- too short to invest
the time and effort to evaluate the risk. Too short, we might
say, to really care.

The plasticity of modern finance -- the ease with which
institutions can transfer risk -- is a major cause of the
heightened frequency of meltdowns and increased volatility. As
with a saloon in which each gunslinger comes armed (and with the
safety catch released), markets resemble a shooting gallery in
which risk takers, each in the name of self-defense, put the
group in peril.

Housing Bubble

Faith in the ability to transfer risk (such as from
mortgage bank to securitization firm to investors) was a major
contributor to the housing bubble. In that case, transferring
risk was a polite term for passing the hot potato. American
International Group Inc., which famously sold credit-default
swaps, was simply the firm holding the most potatoes.

I doubt it’s possible to revert to the world of Old Jamie.
Pundits criticize banks for investing in bonds and putting on
hedges instead of making loans. In reality, modern bankers make
no distinction. They live in a supple world, where every loan,
trade or hedge is simply an exercise in risk transference.
Inundated with data -- much of it ephemeral -- they are prone to
overreact and overtransact, tilting their behavior away from
analysis of long-term credit risk and toward the mentality of
traders.

Bankers are no different from investors in their short-term
focus. We are horrified when bankers lose $3 billion, but the
hedging mentality has also corrupted investors who shrink from a
commitment, finding shelter in a hedge, which Wall Street
peddles in many varieties, including the hedge of extreme and
excessive diversification.

To be meaningful, reform would have to change the culture,
as well as the rules, but here’s a start: Shut down the credit-
default swap pits. Let bankers ply their trade without the
deceptive safety of hedging. Let the speculators bet on
something else.

(Roger Lowenstein is the author of “When Genius Failed:
The Rise and Fall of Long-Term Capital Management.” He is an
outside director with the Sequoia Fund. The opinions expressed
are his own.)